An early warning system for recessions would be a great immune-booster for your financial health.

Stock market downturns during recessions are often deeper (almost 50 percent in 2001) and last longer (the average is about 16 months) than bear markets that occur for other reasons.

“Has the economy been fun for too long?”

Compounding the problem, recessions lead to lower interest rates on savings because the Federal Reserve Board cuts the federal funds rate to boost the economy. Worse yet, layoffs are common during recessions, so you don’t want to make financial decisions that aren’t affordable on unemployment.

The problem is, recessions are difficult to recognize when they arrive and almost impossible to predict. In fact, it takes a while, sometimes a long while, to find out that a recession has already begun. The official announcement of the recession that began in March 2001 didn’t come out until November 2001, eight months later. The announcement of the end of that recession came almost two years after the fact.

What is a recession anyway? In short, it’s a slowing in economic growth. A rule of thumb definition is a decline in the Gross Domestic Product, or GDP, for two or more consecutive quarters — in other words, a decrease for two consecutive quarters in the total market value of what consumers, investors and the government spend (plus the value of exports, minus the value of imports).

Definitions
  • Federal funds rate — The short-term interest rate that banks charge other banks to borrow money overnight at the Federal Reserve.

See the Guide’s Glossary for a further explanation of these terms.

But, the economic good times aren’t officially over until the National Bureau of Economic Research, or NBER, sings. The NBER’s Business Cycle Dating Committee, comprised of business cycle experts, is responsible for calling the start and end of recessions and it places little weight on the GDP. Instead, the committee members evaluate a variety of other economic indicators and statistics to determine whether an economic decline earns the title of recession.

So, a group of experts noodle over numbers for months and finally announce a recession long after it starts. What you need is a way to recognize a recession before your investments and savings interest rates tank. What’s the average Joe supposed to do?

Common sense and keen observation can help you spot the signs of recession, says Don Cassidy, president of the Retirement Investing Institute. Because a recession is a decline in the overall economy, he recommends watching business activity where you live and reading what newspapers and magazines report.

His first and completely unscientific method for deciding whether a recession is on the horizon is, “Has the economy been fun for too long?”

On average, the business cycle represents five or six years of fun times followed by a tough year or two. When the good times roll past that six-year milestone, it’s time to watch for signs that the party is coming to an end.

“When you get stock tips along with a haircut,” says Cassidy, “the game is just about over.”

There are several other nonscientific signals he uses to see whether business is slowing.

Signs of a slowing economy:
  • Less traffic at your local airport means less business and personal travel. Check your local newspaper for airport traffic statistics.
  • More “For lease” signs in storefronts and office buildings when it isn’t right after the holidays could mean businesses are consolidating space or laying off employees.
  • Desperate discounting by airlines, car dealers and stores. “You get 15 percent off coupons for one store item all the time,” says Cassidy. “But 25 percent or 50 percent off any item in the store sounds like desperation.”
  • Politicians and economists start saying “slowing growth” or “soft landing,” because they never want to say the word “recession” too early.
  • Consumer consumption stalls or begins to drop. See whether same store sales growth for companies like McDonald’s is flat or decreasing.
  • Stock prices of major retailers like Target or Kohl’s decrease when the rest of the stock market is reasonably OK.

A contrarian view is another way to recognize the top of the economic cycle, which is by definition the start of a recession. Chances are you’re there when nonfinancial magazines such as Time feature glowing stories about the economy or stock market, or cartoons and television humor joke about how great things are.

Read the tea leaves of the financial markets for a second opinion. Financial market measures aren’t perfect, but you can use them to confirm your personal observations.

John P. Hussman, the president of the Hussman Investment Trust, recommends considering the yield spread between 10-year corporate bonds and 10-year U.S. Treasury bonds to the yield spread six months earlier. A wider spread means that the corporate bond yields are going up and the Treasury yields are going down.

When investors think earnings and default risk are heading higher, they start buying Treasury bonds because they are safer. That makes the T-bond prices go up and their yields go down. At the same time, investors pay less for the more risky corporate bonds, which increases the yields on those bonds.

You can field corporate bond yields at Moody’s whereas Treasury yield curve data is available from the U.S. Department of Treasury.

The yield curve between long-term and short-term investments is another indicator of what the market expects of growth in the future. When the yields on long-term (10-year) Treasury bonds are close to or lower than short-term (three-month) Treasury bills, a recession could be headed our way. When the yield curve is flat or inverted, short-term securities have to pay a higher yield to attract investors, who think the Fed will decide to reduce the federal funds rate to boost the economy.

Definitions
  • Index fund — A fund of stocks that represent a particular index.
  • Moving average — The average price of a security over a specific time period used to spot pricing trends by flattening out large fluctuations.
  • Risk — The probability that the return will be less than expected.
  • Yield curve — A graph that shows the relationship between yields and maturity dates at a given point in time.

See the Guide’s Glossary for a further explanation of these terms.

Another closely watched indicator of slowing business is the Institute for Supply Management’s PMI. This index (originally called the Purchasing Manager’s Index) indicates the level of manufacturing activity nationwide. When the index drops below 50, the overall manufacturing economy is shrinking.

On the bright side, the delay in identifying a recession means that the worst may already be over. You can use these same measures to look for signs of expanding business, too. For example, the stock market tends to hit bottom several months before the end of a recession, giving you time to get on board for the ride up. When bad news doesn’t drive the stock market lower, chances are it has hit bottom.

For a measurable sign that the cycle is on the upswing, look for a 20 percent increase in the 200-day moving average for the S&P. Go to a stock charting Web site, such as Stockcharts.com, and create a chart for an index fund that tracks the S&P 500 index (the Vanguard 500 index fund ticker is VFINX). Include the 200-day moving average as an overlap on the chart.

Watch for the for-lease signs coming down, an increase in the number of columns of job ads in the newspaper and more traffic in the local mall. When you see signs like these, the darkest hour is giving way to the dawn.

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